Natural Gas ETF Filling Up With Hot Air

Investors poured into U.S. Natural Gas ( UNG) last month, and for their efforts, the fund just hit another new 52-week low. It isn't a great vehicle to short natural gas, however, because yesterday the fund's issuer suspended the issuing of new shares pending regulatory approval for a massive expansion.

If there are more buyers than sellers (and interest has been strong), shares are likely to trade at a premium even if the price of natural gas declines -- something the fundamentals and technicals would imply.

Even though the fund is a huge portion of the futures market, it is not a large portion of the overall natural gas market. As of last week, inventory was 20% above the five-year average, according to the Energy Information Administration. Natural gas consumption is split almost evenly across industrial, residential and commercial and electric power demand. Meanwhile, 70% of petroleum flows to the transportation sector of the economy.

The difference may account for why natural gas prices have remained stubbornly low, along with the fact that natural gas is produced domestically. Economic weakness in the manufacturing sector, consumers tightening their belts and a cool summer in many parts of the country are all playing a role in lower prices. In addition, natural gas is produced domestically, and in the absence of a natural gas cartel in this country and aside from drilling restrictions, the market is relatively free.

As crude oil was marching higher in the spring and PowerShares DB Oil ( DBO) was advancing more than 60% from mid-February into June, natural gas plumbed its lows, with U.S. Natural Gas ( UNG) down nearly 30% at a new 52-week low.

The frenzy into UNG was based on speculation that natural gas would follow oil and that the ratio between crude oil and natural gas prices would shrink from extreme levels back into the historical range. Ratios have two ways of closing though -- the undervalued asset can rally or the overvalued asset can decline.

Over the course of several days, it appears the latter is more likely than the former. Oil prices have come down from the low-$70s to the low-$60s. DBO declined from $26.35 on June 11 to $23.16 yesterday, a loss of 12.1%. Over the same period, PowerShares DB Crude Oil Double Short ( DTO) climbed from a low of $66.66 to $90.77, a gain of 36.2%. Meanwhile, UNG is down from a high of $15.88 on June 17, to $12.18, a loss of 23.3% ... and the oil/gas price ratio remains at roughly the same level as before.

Investors would be wise to avoid stepping in front of a moving train or trying to catch falling knives, but short ETFs and ETNs allow investors to follow the trend. PowerShares DB Crude Oil Double Short ETN ( DTO) is a functional security that will deliver positive returns if oil slides.

Much of this move may already be behind us, but aggressive traders can still profit. These are not positions to buy and hold, however, so make use of stops. For more information on UNG, see my previous article. Also check out my RealMoney post about an ETF made up of natural gas stocks.

At the time of publication, Dion had no positions in the stocks mentioned.

Don Dion is the publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.

Dion is also president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.